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How ripple works?

Ripple’s website describes the open-source protocol as “basic infrastructure technology for interbank transactions–aneutral utility for financial institutions and systems.” The technology allows banks and non-bank financial services companies to incorporate the Ripple protocol into their own systems, and therefore allow their customers to use the service. Currently, Ripple requires two parties for a transaction to occur: first, a“regulated financial institution” which holds funds and issues balances on behalf of customers. Second, “market makers” such as hedge funds or currency trading desks which provide liquidity in the currency they want to trade in. At its core, Ripple is based around a shared, public database or ledger that has its contents decided on by consensus. In addition to balances, the ledger holds information about offers to buy or sell currencies and assets, creating the first distributed exchange. The consensus process allows for payments, exchanges and remittance in a distributed process. In Ripple, users make payments between each other by using cryptographically signed transactions denominated in

either fiat currencies or Ripple’s internal currency (XRP). For XRP-denominated transactions Ripple can make use of its internal ledger, while for payments denominated in other assets, the Ripple ledger only records the amounts owed, with assets represented as debt obligations. As originally Ripple only kept records in its ledger and has no real-world enforcement power, trust was required. However, Ripple is now integrated with various user verification protocols and bank services. Users have to specify which other users they trust and to what amount. When a non-XRP payment is made between two users that trust each other, the balance of the mutual credit line is adjusted, subject to limits set by each user. In order to send assets between users that have not directly established a trust relationship, the system tries to find a path between the two users such that each link of the path is between two users that do have a trust relationship. All balances along the path are then adjusted simultaneously and atomically. This mechanism of making payments through a network of trusted associates is named ‘rippling’. It has similarities to the age-old hawala system. The Ripple code is open source and available for the public, this means that anyone can deploy a Ripple instance. Nodes can take up to three different roles in Ripples:
users which make/receive payments, market makers which act as trade enablers in the system, and validating servers which execute Ripple’s consensus protocol in order to check and validate all transactions taking place in the system.

A. Gateways

gateway is any person or organization that enables users to put money into and take money out of Ripple’s liquidity pool. A gateway accepts currency deposits from users and issues balances into Ripple’s distributed ledger. Furthermore, gateways redeem ledger balances against the deposits they hold when currency is withdrawn. In practice, gateways are similar to banks, yet they share one global ledger known as the Ripple protocol. Depending on the type and degree of interaction a user has with a gateway, the gateway may have anti-money laundering (AML) or know your customer (KYC) policies requiring verification of identification, address, nationality, etc. to prevent criminal activity. Popular gateways as of 2017 included Bitstamp, Gitthub, Ripple Fox, Tokyo JPY, Mr. Ripple, Ripple China and The Rock Trading. Users must ‘extend trust’ to the Ripple gateway that holds their deposit. This manual creation of a trust line indicates to the Ripple network that the user is comfortable with the gateway’s counter party risk. Furthermore, the user must put a quantitative limit on this trust and create a similar limit for each currency on deposit at that gateway. For example, if a user deposits US$50 and BTC 2.00 at The Rock Trading, the user will have to grant trust of at least that much in both currencies to the gateway for the monies to be available in the Ripple network. When a user has allowed multiple gateways in the same currency, there is an advanced option to allow “rippling,” which subjects the user’s balance of that currency to switch (or ripple) between gateways. Though their total balance doesn’t alter, users earn a small transit fee for providing inter-gateway liquidity.

B. Consensus Ledger

Ripple relies on a common shared ledger, which is a distributed database storing information about all Ripple accounts. The network is “managed by a network of independent validating servers that constantly compare their transaction records.” Servers could belong to anyone, including banks or market makers.
Though the Ripple protocol is freeware, Ripple Labs continues to develop and promote the Ripple protocol, which confirms financial transactions via a network of distributed servers. Ripple Labs is currently assisting banks in integrating with the Ripple network.A new ledger is created every few seconds, and the last closed ledger is a perfect record of all Ripple accounts as determined by the network of servers. A transaction is any proposed change to the ledger and can be introduced by any server to the network. The servers attempt to come to consensus about a set of transactions to apply to the ledger, creating a new ‘last closed ledger’. The consensus process is distributed, and the goal of consensus is for each server to apply the same set of transactions to the current ledger. Servers continually receive transactions from other servers on the network, and the server determines which transactions to apply based on if a transaction came from a specified node in the ‘unique node list’ (UNL). Transactions that are agreed upon by a “supermajority” of peers are considered validated. If the supermajority isn’t in consensus, “this implies that transaction volume was too high or network latency too great for the consensus process to produce consistent proposals,” then the consensus process is again attempted by the nodes. Each round of consensus reduces disagreement, until the supermajority is reached. The intended outcome of this process is that disputed transactions are discarded from proposals while widely accepted transactions are included. While users may assemble their own UNL nodes and have full control over which nodes they trust, Ripple Labs acknowledges that most people will use the default UNL supplied by their client. While transaction information on the ledger is public, payment information is not. It’s thus difficult for anyone to associate transaction information with any specific user or corporation.

C. Market makers

Any user on Ripple can act as a market maker by offering an arbitrage service such as providing market liquidity, intra-gateway currency conversion, rippling, etc. Market makers can also be hedge funds or currency trading desks. According to the Ripple website, “by holding balances in multiple currencies and connecting to multiple gateways, market makers facilitate payments between users where no direct trust exists, enabling exchanges across gateways.” With a sufficient number of market makers, the path finding algorithm creates a near friction less market and enables users to seamlessly pay each other via the network in different currencies, without assuming any undesired foreign exchange risk. Many such services are offered through a traditional platform of offers to buy or sell one currency for another currency. Bids and asks are aggregated into order books, to create a decentralized exchange. Users can transact with market makers to trade or convert currencies. Ripple’s path finding algorithm leverages this functionality to allow users to send money in one currency and the recipient to receive it in another currency. For example, a user can pay with USD and the recipient can choose to receive the money in another currency, including bitcoins and XRP.